What Will the Accounting Change Mean to Apple?

As most followers of Apple, Inc. know, accounting rules were changed a few months ago that allow Apple to change its method of accounting for iPhone sales. I am convinced that the accounting change is imminent, which begs the question – What will it mean for Apple (the company) and for AAPL (the stock)?

I make my living as a venture capital investor and as a company CFO, so I know my way around accounting rules – and especially through the thicket of choosing among various acceptable accounting methodologies (and then living with those choices). But even I don’t find this type of discussion particularly exciting. So I apologize in advance for being boring in this post.

First, a little background is in order. When Apple began selling the iPhone (and before that, with AppleTV), accounting rules in effect at the time required that the company make a choice. The company had to choose to account for iPhone revenues under the sale method or under the subscription method. Under the sale method, all of the money received is recognized as revenue at the time of the original transaction. Under the subscription method, the money received is recognized as revenue over the term of the “subscription” – which for our purposes is over two years.

On its face, this seems like an easy choice. The whole idea of selling products is to get revenue, so more revenue sooner has got to be a good thing, right? Unfortunately, it is not quite that easy. If revenue is recognized under the sale method, then any new delivery of value (for example, an update of the phone’s operating system) would require a charge to the customer. If this sounds familiar, it is because Apple chose to use the sale method to recognize revenue from the iPod touch. For the iPhone, however, the company choose to use the subscription method, under which software updates could be delivered to customers for free.

I believe that the decision of which accounting method to use had little to do with company operations and even less to do with having the company’s accounting method most accurately reflect the business. Instead, I believe that it was an audacious attempt on the part of Apple to deliver value to the public stock markets. An attempt that did not work, but that was laudable nevertheless.

Investors in the public stock markets value not just high revenues and profits, but especially value a company’s ability to accurately predict what its revenues and profits will be in the future. This is called “quality of earnings” because a company that is able to build a track record of accurately predicting future results is much less risky than a company that is not accurate (or one that refuses to share its projections).

Apple has a long history of having quarterly revenue and earnings that meet or exceed its predictions. Peter Oppenheimer (Apple’s CFO) has often told market analysts that the predictions he shares with them present numbers that Apple’s executive team are very comfortable that they will be able to deliver. In other words, when Apple shares a prediction, the company is not really sharing what it thinks will happen, but rather what it thinks is the absolute minimum of what will happen.

When a company forecasts below its actual prediction by a little bit and now and then, it is called being conservative – and is considered to be a good thing. When it is done consistently and by a large margin, it is called “sandbagging” – and considered by market analysts to be insulting. Under Peter Oppenheimer, Apple has raised sandbagging to a high art.

As a former public-company CFO myself, I applaud both his audacity in doing so, and his skill in sandbagging so well and for so long.

I believe that Apple’s decision to account for revenues from iPhone under the subscription model was to attempt to deliver even higher “quality of earnings” by shifting more and more of its revenue over time to a guaranteed stream of revenue from past iPhone sales. In theory, analysts would understand that Apple was receiving the cash each time an iPhone was sold, so the investor community would know that Apple’s actual business was much, much stronger than what the accounting statements seemed to show.

In actuality, the investor community either did not understand the difference between the sale method and the subscription method, or refused to give Apple credit for the quality of earnings represented by the subscription method. In my own opinion, analysts collectively were engaging in payback for Apple’s sandbagging through the years.

Whatever the reason, Apple has been valued based on stated earnings per share (EPS) rather than cash being generated even though the deferred revenue (and cash in the bank) from the subscription method was getting larger and larger.

So now, the billion-dollar question: with Apple on the verge of converting from the subscription method to the sales method for iPhone revenues, what will happen?

For Apple, Inc. (the company), there should be no change at all. The company will continue to sell iPhones in higher and higher numbers and will continue to collect boatloads of cash. Nothing operational is being changed in any way.

For AAPL (the stock), I expect a very large change. The stated revenues, earnings and EPS will suddenly be much larger, even though the company’s actual sales do not change a bit. This means that the price/earnings ratio – which is used throughout the investing world to compare one company to another in search of bargains – will suddenly highlight AAPL is a bargain-basement stock that is growing rapidly rather than a stock priced at a premium because of its growth. I expect the stock price to jump up significantly within days, hours or minutes of the first release of quarterly earnings by Apple with the new accounting treatment.

And I expect that first release to occur this month – on January 25, 2010 immediately following market close.

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8 responses to “What Will the Accounting Change Mean to Apple?”

TS2K … Thanks for your cogent analysis. Members of the financial press and far too many unenlightened analysts, look at Apple’s (AAPL) financial data and they see a stock that had a nice run from March 2009 lows and is now priced at “30 times earnings.” What they don’t understand, or fail to acknowledge, is that Apple’s NON-GAAP numbers present a more accurate picture of current operations. The NON-GAAP numbers show the full/immediate and substantial revenue contributions to EPS from iPhone sales. Broadpoint AmTech analyst Brian Marshall estimates that iPhone will contribute $20 billion to Apple’s revenue in 2010.

I look forward to Apple’s Jan 2010 earnings report. This report should reflect the accounting change and may halve Apple’s forward PE. It’s wake up time for many analysts!

You have it exactly right, Dan. It makes me wonder how (and why) highly paid financial analysts do not seem to understand. I am not a conspiracy theorist, so I don’t attribute it to all of the analysts working together to depress the Apple stock price – I think it is more laziness on the part of the analysts.

I am very much looking forward to seeing the impact of the accounting change!

Excellent analysis. As a former COO of a public company i understand the importance and impact this decision will have on Apple’s stock.

My question is: will the sales recognition rule change iPhone software updates to be charged items? If so , we need to inform the iPhone user community of this. I don’t believe that many are aware of these changes.

Hi Ramon – The account rule change that was approved back in September means that Apple does NOT need to charge for iPhone software items. In fact, if Apple chooses to do so, it can now stop charging when it issues software updates for iPod touch.

Thanks for your response. Your analysis is the clearest I’ve read thus far on this subject. I watch CNBC avidly and have not come across any such commentary. I believe it would be useful for investors to get in on this since it could boost Apple stock over the 300 level.

I noticed you did not factor in the impact of the Apple Tablet. I read yesterday in fortune that investors are paying a premium of 25 billion dollars in AAPL stock value. I would love to see your blog piece on this matter as its happening.

You are right – I wanted to highlight that the impending accounting change for Apple would likely have a significant impact on the AAPL price completely separate from any changes in the ongoing business.

So, I did not factor in market share growth (which is happening in computers and in phones for Apple), nor did I factor in any impact of new products (like the rumored tablet). In my opinion, there are more than enough people speculating on the impact that an unannounced product is likely to have. I’ll wait for some facts before sharing any opinion.

I do have an opinion about whether or not investors are currently paying a premium for AAPL. Assuming for the moment that Fortune’s calculation is correct (and I don’t think it is), I think that Fortune missed an important last step in their calculation – which would be to back out the cash and short-term securities that Apple has on their books. I believe that this is now more than $30 billion. So, if I take the Fortune “premium” of $25 billion and offset it by the cash, then investors are actually getting shares of AAPL at a $5 billion discount from a fair value.